The Internal Revenue Code & ERISA does not describe what a Self-directed IRA or Solo 401(k) plan can invest in, only what it cannot invest in. Internal Revenue Code Sections 408 & 4975 prohibits Disqualified Persons from engaging in certain type of transactions. The purpose of these rules is to encourage the use of qualified retirement plans for accumulation of retirement savings and to prohibit those in control of the retirement account and from taking advantage of the tax benefits for their personal account.
Who is a “Disqualified Person”?
The IRS has restricted certain transactions between the Solo 401(k) Plan and a “disqualified person”. The rationale behind these rules was a congressional assumption that certain transactions between certain parties are inherently suspicious and should be disallowed. The definition of a “disqualified person” (Internal Revenue Code Section 4975(e)(2)) extends into a variety of related party scenarios, but generally includes the Solo 401(k) Plan Participant, any ancestors or lineal descendants of the Solo 401k Plan Participant, and entities in which the Solo 401(k) Plan Participant holds a controlling equity or management interest. In essence, under Code Section 4975, a “Disqualified Person” means:
- A fiduciary (e.g., the Solo 401(k) Plan Participant, or person having authority over making Solo 401(k) Plan investments),
- A person providing services to the Solo 401(k) Plan (e.g., the trustee or custodian),
- An employer, any of whose employees are covered by the plan (this generally is not applicable to Solo 401k Plans but does include the owner of a business that establishes a qualified retirement plan),
- An employee organization any of whose members are covered by the Solo 401k Plan,
- A 50 percent owner of C or D above,
- A family member of A, B, C, or D above (family members include the fiduciary’s spouse, parents, grandparents, children, grandchildren, spouses of the fiduciary’s children and grandchildren (but not parents-in-law),
- An entity (corporation, partnership, trust or estate) owned or controlled more than 50 percent by A, B, C, D, or E. Whether an entity is a disqualified person is determined by considering the indirect stockholdings/interest which would be taken into account under Code Sec. 267(c), except that members of a fiduciary’s family are the family members under Code Sec. 4975(e)(6) (lineal descendants) for purposes of determining disqualified persons.
- A 10 percent owner, officer, director, or highly compensated employee of C, D, E, or G,
- A 10 percent or more partner or joint venturer of a person described in C, D, E, or G.
Note: brothers, sisters, aunts, uncles, cousins, step-brothers, step-sisters, and friends are NOT treated as “Disqualified Persons”.
Pursuant to Internal Revenue Code Section 4975, a self-directed IRA or Solo 401(k) Plan Participant is prohibited from engaging in certain types of transactions. The types of prohibited transactions can be best understood by dividing them into three categories: Direct Prohibited Transactions, Self-Dealing Prohibited Transactions, and Conflict of Interest Prohibited Transactions.
Direct Prohibited Transactions
Subject to the exemptions under Internal Revenue Code Section 4975(d), a “Direct Prohibited Transaction” generally involves one of the following:
4975(c)(1)(A): The direct or indirect Sale, exchange, or leasing of property between a Solo 401k Plan and a “disqualified person”
Example 1: Joe sells an interest in a piece of property owned by his Solo 401k Plan to his son.
Example 2: Beth leases real estate owned by her Solo 401k Plan to her daughter.
Example 3: Mark uses his Solo 401k Plan funds to purchase an LLC interest owned by his mother.
4975(c)(1)(B): The direct or indirect lending of money or other extension of credit between a Solo 401k Plan and a “disqualified person”
Example 1: Ted lends his wife $70,000 from his Solo 401k Plan.
Example 2: Mary personally guarantees a bank loan to her Solo 401k Plan to purchase real estate.
Example 3: Dan uses his Solo 401k Plan funds to lend an entity owned and controlled by his father $18,000.
1. IRA Can Own 100% of a Newly Established Entity and be Managed by the IRA Holder and Not Trigger a Prohibited Transaction | Swanson V. Commissioner 106 T.C. 76 (1996)
The idea of using an entity owned by an IRA to make investments was first reviewed by the Tax Court in Swanson V. Commissioner 106 T.C. 76 (1996).
Underlying Dispute: The underlying facts involved James Swanson (the taxpayer’s) combined use of two entities owned exclusively by his IRAs to defer income recognition. James Swanson was the sole shareholder of H & S Swansons’ Tool Company, an S corporation that builds and paints component parts for domestic and foreign equipment manufacturers. Following the advice of tax counsel, Swanson arranged in 1985 for the establishment of Swansons’ Worldwide, Inc. (“Worldwide”), a Domestic International Sales Company (“DISC”). A DISC is a domestic corporation, usually a subsidiary, that is typically used to defer tax on income generated by the entity. Mr. Swanson appointed Florida National Bank as trustee and custodian of IRA #1, who retained the power to direct its investments. Mr. Swanson then directed Florida National to execute a subscription agreement to purchase 2,500 shares of Worldwide original issue stock. The shares were issued and IRA #1 became the sole shareholder of Worldwide. Mr. Swanson then engineered a similar transaction with a second IRA at another bank.
The IRS Attack: The IRS issued a notice of deficiency to Mr. Swanson in June 1992. The IRS stated that prohibited transactions had occurred causing IRAs #1 and #2 to be terminated. The IRS made the following arguments:
- Mr. Swanson is a disqualified person within the meaning of section 4975(e)(2)(A) of the Code as a fiduciary because he has the express authority to control the investments of IRA#1.
- Mr. Swanson is also an Officer and Director of Swansons’ Worldwide. Therefore, direct or indirect transactions described by section 4975(c)(1) between Swansons’ Worldwide and IRA #1 constitute prohibited transactions.
- Mr. Swanson, as an Officer and Director of Worldwide directed the payment of dividends from Worldwide to IRA #1.
- At the time of the purchase of the Swanson Worldwide stock, Mr. Swanson was a fiduciary of his IRA and the sole director of Swansons’ Worldwide.
- The sale of stock by Swanson Worldwide to Mr. Swanson IRA constituted a prohibited transaction within the meaning of Section 4975(c)(1)(A) of the Code.
Mr. Swanson’s Position in Response to the IRS: Mr. Swanson took the position in their Tax Court petition that no prohibited transaction had occurred. Their position was that since the Worldwide shares issued to IRA #1 were original issue, no sale or exchange occurred. Also, they stated that as director and president of Worldwide, Swanson engaged in no activities on behalf of Worldwide that benefited him other than as beneficiary of IRA #1. Mr. Swanson made similar points with respect to IRA #2.
The IRS Concedes the Prohibited Transaction Issue: The IRS conceded the prohibited transaction issue in the Swanson case on July 12, ’93 when it filed a notice of no objection to an earlier motion by the Swansons’ for partial summary judgment on that issue. Mr. Swanson sought litigation costs against the IRS on the Prohibited Transaction Issue. The Tax Court Rebuffs IRS Arguments on IRA Prohibited Transaction Issue and Imposes Litigation Costs. The IRS argued that its litigation position with respect to the IRA prohibited transaction issue was substantially justified. The Tax Court disagreed with the IRS’ position, finding that it was unreasonable for the IRS to claim that a prohibited transaction occurred when Worldwide’s stock was acquired by IRA #1 for the following reasons:
- The stock acquired was newly issued. Before that time, Worldwide had no shares or shareholders. A corporation without shares doesn’t fit within the definition of a disqualified person under the prohibited transaction rules. As a result, Mr. Swanson only became a disqualified person with respect to IRA #1 investment into Worldwide only after the Worldwide stock was issued to IRA #1.
- It was only after Worldwide issued its stock to IRA #1 that Mr. Swanson held a beneficial interest in Worldwide’s stock. Mr. Swanson was not a “disqualified person” as president and director of Worldwide until after the stock was issued to IRA #1
- The payment of dividends by Worldwide to IRA #1 was not a self-dealing prohibited transaction under Internal Revenue Code Section 4975(c)(1)(E). The only benefit Mr. Swanson realized from the payments of dividends by Worldwide related solely to his status as beneficiary of IRA #1 which is not a prohibited transaction.
- It was only after Worldwide issued its stock to IRA #1 that Mr. Swanson held a beneficial interest in Worldwide’s stock. Therefore, the issuance of stock to IRA #1 did not, constitute a prohibited transaction.
- It was only after Worldwide issued its stock to IRA #1 that Mr. Swanson held a beneficial interest in Worldwide’s stock. Mr. Swanson’s only benefit would be as beneficiary of the IRA which is not a prohibited transaction.
The Tax Court reached similar conclusions with respect to IRA #2. The Tax Court agreed with Swanson that the IRA argument that an IRA can not own a new entity to make an investment is a frivolous position that should be sanctioned and subject to litigation fees.
“We must apportion the award of fees sought by petitioners (Swanson) between the DISC (IRA) issue, for which respondent (IRS) was not substantially justified.”
-Tax Court in Swanson V. Commissioner 106 T.C. 76 (1996).
What did we learn from the Swanson Tax Court case?
- An IRA can own an Interest in a New Entity managed by the IRA holder. The Swanson case helped establish that an IRA holder is permitted to establish a new entity wholly owned by his or her IRA in order to make IRA investments. The Swanson case makes it clear that only after the IRA has acquired the stock of the newly established entity does the entity become a disqualified person.
- An IRA Holder can manage the newly formed entity owned by the IRA. The Swanson case makes it clear that an IRA holder may serve as manager, director, or officer of the newly established entity owned by his or her IRA. The Tax Court held that Mr. Swanson was not a “disqualified person” as president and director of Worldwide until after the stock was issued to IRA #1. In other words, by having the IRA invested in an entity such as an LLC of which the IRA owner is the manager, the Swanson Case suggests that the IRA holder can serve as manager of the LLC and have “checkbook control” over his or her IRA funds.
The Tax Court in Swanson made it clear that it was only after Worldwide issued its stock to IRA #1 that Mr. Swanson held a beneficial interest in Worldwide’s stock. Therefore, the Tax Court is arguing that only once the IRA funds have been invested into the newly established entity does the analysis begin whether an IRA transaction is prohibited. Said another way, the Tax Court is contending that the use of an entity owned wholly by an IRA is not material as to whether a prohibited transaction occurred. The use of a wholly owned entity to make an investment is essentially no different if the IRA made the investment itself with respect to the prohibited transaction rules.
2. The IRS Offers Guidance to its Audit Agents on the Legality of the Checkbook Control IRA | IRS Field Service Advice (FSA) Memorandum 200128011
IRS Field Service Advice (FSA) Memorandum 200128011 was the first IRS drafted opinion that confirmed the ruling of Swanson that held that the funding of a new entity by an IRA for self directing assets was not a prohibited transaction pursuant to Code Section 4975. An FSA is issued by the IRS to IRS field agents to guide them in conduct of tax audits. The facts presented in the FSA clearly mirrored those in the Swanson case.
The Facts: USCorp is a domestic sub-chapter S Corporation. Father owns a majority of the shares of USCorp. Father’s three minor children own the remaining shares of USCorp equally. USCorp is in the business of selling Product A and some of its sales are made for export. Father and each child own separate IRAs. Each of the four IRAs acquired a 25% interest in FSC A, a foreign sales corporation (“FSC”). USCorp entered into service and commission agreements with FSC A. During Taxable Year 1, FSC A made a cash distribution to its IRA shareholders, out of earnings and profits derived from foreign trade income relating to USCorp exports. The IRAs owning FSC A each received an equal amount of funds.
The IRS Opinion & Confirmation of the Legality of the Checkbook IRA: IRS advised that, based on Swanson, neither issuance of stock in the newly established entity (FSC) to the IRAs owners nor the payment of dividends by the FSC to the IRAs constituted direct prohibited transaction.
“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…..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).”
IRS in FSA Memorandum 200128011: “this case should not be pursued as one involving prohibited transactions”
3. Paying Off a Personal Loan with Retirement Funds is a Prohibited Transaction | Technical Advice Memorandum 9713002
This memorandum also involves a plain vanilla prohibited transaction involving the transfer of property. Here, Individual A was the sole owner, President and director of an employer, which was set up as a corporation. The employer adopted two plans (Plan X and Plan Y), and A was the sole trustee of each plan. A caused both plans to issue a series of loans to himself. The loans were evidenced by promissory notes with a stated rate of interest, but with no fixed term or collateral. Eventually A repaid the outstanding balance on the loans by transferring to the plans a 50% interest in real estate in partial satisfaction of the loans, and then paid the remaining balance in cash.
The IRS concluded that the transfer of the 50% real estate from A to the plans was a prohibited transaction under 4975(c)(1)(A). A was clearly a disqualified person for 3 reasons. A was a fiduciary under 4975(e)(2)(A) – A was the sole trustee of Plan X and Plan Y, and, as the pattern of taking personal loans demonstrated, regularly exercised unhindered control over the management and disposition of plan assets. In addition, because Individual A was the 100 percent owner of the Employer, the corporation which was the employer of all of the employees covered by Plan X and Plan Y, A was disqualified under 4975(e)(2)(E) for having owned more than 50% (here, 100%) of the corporation which was the employer of all the employees covered by Plan X and Plan Y. Finally, as an officer, a director, and a 10 percent or more (again, 100%) shareholder of the corporation which was the employer of all of the employees covered by Plan X and Plan Y, A was disqualified under 4975(e)(2)(H).
Notably, the fact that Individual A may have undertaken this transaction in order to repay a portion of the outstanding principal loan balance plus interest which he owed to Plan X and Plan Y did not save the transaction from being prohibited under Section 4975.
Using Personal Assets as Security for a Retirement Plan is a Prohibited Transaction
4. ERISA Opinion Letter 2009-03A
This is an instructive opinion involving the pledge of personal assets as security to a brokerage firm (“Broker”) in order to establish a self-directed IRA with that same Broker. Here, an IRA owner had a personal brokerage account with the Broker, and wanted to open a self-directed IRA (i.e., will self-direct investments made with IRA assets) with the Broker. The Broker conditioned opening the IRA on the IRA owner pledging the assets in his personal brokerage account with the Broker to cover indebtedness that the IRA may occur.
The DOL concluded that this arrangement – i.e., the grant by an IRA owner to the Broker of a security interest in his non-IRA accounts to cover any indebtedness of his IRA – was a prohibited transaction under 4975(c)(1)(B). The IRA owner, having the ability to self-direct IRA investments, was clearly a fiduciary and a disqualified person with respect to the IRA. 4975(c)(1)(B) prohibits the direct or indirect lending of money or other extension of credit between a plan and a disqualified person. In the DOL’s view, the granting of a security interest in the IRA owner’s personal accounts to cover indebtedness of, or arising from, the IRA constitutes such an extension of credit precluded by (c)(1)(B). The requested granting of a security interest in the assets of the IRA owner’s personal accounts to the Broker to cover the IRA’s debts to the Broker is akin to a guarantee of such debts by the IRA owner, and it was clear from ERISA’s legislative history and prior DOL guidance that a guarantee of a plan’s indebtedness by a disqualified person is an extension of credit to the plan in violation of (c)(1)(B).
Furthermore, the DOL noted that if the IRA owner instead granted to the Broker a security interest in the IRA’s assets (as opposed to the owner’s non-IRA assets) to cover the IRA owner’s own indebtedness (rather than the IRA’s debt), that would likely result in prohibited transactions under 4975(c)(1)(B), (D) and (E)! Granting such a security interest would amount to an extension of credit by the IRA to the IRA owner in violation of (c)(1)(B). Also, by granting a security interest in the IRA’s assets, the IRA owner would be transferring or using the IRA’s assets for his own benefit in violation of (c)(1)(D). Finally, the IRA owner would be using the IRA’s assets in his own interest or for his own account in violation of (c)(1)(E).
5. Purchasing Corporation Stock That is Not Deemed a Disqualified Person May Not Be a Prohibited Transaction | ERISA Advisory Opinion Letter 89-03
In this opinion a husband and wife, Mr. and Mrs. Bowns, Frances, owned a small amount of shares in a corporation personally. Mr. Bowns was also an officer of the corporation and general manager of one of its business divisions. In addition, Mr. and Mrs. Bowns established IRAs. They were the only participants in their respective IRAs and had reserved the right to direct their IRA investments. Mr. and Mrs. Bowns proposed to direct their respective IRA trustees to purchase shares of the corporation on behalf of each of their IRAs for no more than adequate compensation.
The issue before the DOL was whether this proposed investment by each of the IRAs constitute a prohibited transaction under 4975(c)(1)(A). Mr. and Mrs. Bowns were fiduciaries and, thus, disqualified persons with respect to their IRAs because of their authority under the IRAs to direct investments. At issue was whether the corporation was also a disqualified person. The DOL concluded it was not. Section 4975(e)(2)(C) provides that a disqualified person includes an employer any of whose employees are covered by the plan. The DOL noted that although Section 4975 does not define the term employer, Section 3(5) of ERISA provides, in part, that an employer is any person acting as an employer in relation to an employee benefit plan. Because it was represented that the corporation had no involvement with the establishment or maintenance of the IRAs, the DOL concluded that the corporation was not a disqualified person with respect to the Bowns’ IRAs under Section 4975(e)(2)(C). In addition, the corporation was not a disqualified person under Section 4975(e)(2)(G) because the aggregate stock ownership by the Bowns in the corporation was well less than 50% (their direct ownership, taking into account the exercise of various stock options, amounted to about 1.2%). Therefore, the purchase of stock by the IRAs in the corporation would not violate 4975(c)(1)(A).
However, the Court noted that the conclusion does not preclude the existence of other prohibited transactions under IRC Code Section 4975(c)(1)(D) or (E) under the self-dealing and conflict prohibited transaction rules. IRC Section 4975(c)(1)(D) 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. IRC Section 4975(c)(1)(E) prohibits a fiduciary from dealing with the income or assets of a plan in his own interest or for his own account.
6. Purchasing Corporation Stock That is Not Deemed a Disqualified Person May Not Be a Prohibited Transaction | PLR 8717079
This Private Letter Ruling is very similar to the Bowns opinion above (89-03). Much like that opinion, here Individual N proposed to have his/her IRA to purchase shares in a corporation in which Individual N was employed as its accounting manager and was a member of its board of directors. Individual N also owned less than 1% of the common stock of the Company and after the proposed purchase by the IRA Individual N’s total investment would still be less than 1%. The IRS ruled that the investment was not a prohibited transaction under 4975(c)(1)(A). Even though Individual N was clearly a fiduciary and disqualified person, the corporation was not disqualified because it was not an employer in relation to the IRA itself and thus did not fall under 4975(e)(2)(C). The IRS considered an employer to be acting in relation to an IRA “only when it is involved in maintaining, sponsoring, or contributing directly to the IRA.” None of that was true in this case.
7. Using a Self-Directed IRA To Invest in a Corporation Owned Less than 50% By a Disqualified Person Not a Prohibited Transaction, but beware of Self-Dealing prohibited Transaction Rules | PLR 8009091
This Private Letter Ruling is also similar to the Bowns opinion (89-03). In this ruling, an individual was a director and former employee of Corporation A. The same individual was also the President of Corporation B, which owned 35% of Corporation A. The individual had set up an IRA with Bank A as trustee, with the individual retaining the right to direct the trustee to make the IRA’s investments. No other employees of Corporation A were covered under the IRA.
The IRA owner proposed to cause his IRA to buy up to 5% of Corporation A’s stock. The IRS ruled that the proposed transaction was not a prohibited transaction under 4975(c)(1)(A) (i.e., no direct/indirect sale or exchange of property between a plan and a disqualified person) because Corporation A was not a disqualified person with respect to the IRA. But the IRS noted that if the IRA owner, which was a fiduciary of the IRA, were to benefit directly or indirectly from the IRA’s stock purchase in a capacity other than as the IRA’s participant (such as insuring his reelection to Board of Corporation A or improving his position as President of Corporation B), the transaction would be prohibited under Code Sections 4975(c)(1)(D), (E) and/or (F). The IRS did not make a determination as to whether or not the IRA owner derived such a benefit due to its factual nature. The Court further stated that if it can be shown that the IRA holder directly or indirectly benefited from the transaction, the transaction could violate the self-dealing or conflict of interest prohibited transaction rules under IRC 4975(c)(I)D and (E). Nevertheless, this ruling is instructive as to what might constitute a prohibited benefit to a fiduciary.
8. Lending Funds to a Related Corporation is a Prohibited Transaction | Zacky v. Commissioner, TC Memo 2004-130
The Zacky case involved three separate loans all of which were prohibited transactions under Section 4975(c)(1)(B), (D) and (E).
The taxpayer, Mr. Zacky, was the president and sole owner of Aspects Inc. (“Aspects”), a corporation that maintained a qualified profit sharing plan. Mr. Zacky was one of many participants under the plan and also served the plan’s sole trustee. Mr. Zacky borrowed funds (Loan #1) from the plan to pay Aspects payroll liability that was about to become due.
At some point thereafter the plan lent funds (Loan #2) to a related corporation, Inland Empire Properties, Inc. (“Inland”). Mr. Zacky was also the president and sole owner of Inland, which had no other employees. Inland owned and leased to Aspects and other tenants a commercial building. The purpose of Loan #2 was to enable Mr. Zacky to pay off an outstanding car loan, and to that end Mr. Zacky transferred title to the vehicle to Inland shortly after Loan #2 was made.
Subsequent to Loan #2, the plan made another loan to Inland (Loan #3) to enable Inland to pay mortgage and real estate taxes due on the building it owned.
No principal or interest had been paid on any of the loans. Moreover, Mr. Zacky, in his capacity as the plan’s trustee, did not seek nor attempt to compel repayment (but did require two loans to other participants to be repaid).
Mr. Zacky did not dispute that he was a disqualified person – he was disqualified as a fiduciary under 4975(e)(2)(A) and under (e)(2)(E) as the owner of Aspects, an employer any of whose employees are covered by the plan. Inland was also a disqualified person under 4975(e)(2)(G) because it was a corporation at least 50% of which (here, 100%) was owned by a fiduciary (Zacky). Nor did he dispute that the Aspects’ plan was a “plan” under 4975(e)(1)(A). Therefore, the Tax Court concluded that all three loans were prohibited transactions under Section 4975(c)(1)(B), (D) and (E). Under 4975(c)(1)(B), each loan involved a direct or indirect lending of money between a plan and a disqualified person (either Zacky or Inland). In addition, each loan was a direct or indirect transfer to, or use by or for the benefit of, a disqualified person of the income or assets of the plan in violation of 4975(c)(1)(D). Each loan benefitted Zacky, a disqualified person. Loan #1 was used to pay off his wholly owned company’s (Aspects) payroll liability. Loan #2 was used to pay off his personal car payment. Loan #3 was used to pay the mortgage and real estate taxes owed by his other wholly owned company (Inland). Finally, each loan was a direct or indirect act by a disqualified person who is a fiduciary (i.e., Zacky) whereby he deals with the income or assets of a plan in his own interest or for his own account.
In so ruling, the Tax Court rejected several arguments advanced by Zacky that the loans were not prohibited. Zacky first argued that the loans were permitted by the plan. Specifically, Sec. 7.4 of the plan permitted loans to participants under the following conditions: (1) loans were made available to all participants and beneficiaries on a reasonably equivalent basis; (2) loans shall not be available to highly compensated employees in an amount greater than the amount available to other participants and beneficiaries; (3) loans shall bear a reasonable rate of interest; (4) loans were adequately secured; and (5) loans provided for repayment over a reasonable period of time. The Tax Court determined that under these terms Loan #1 was not permitted as it had yet to be repaid (thereby not meeting the 5th requirement). Moreover, Loans #2 and 3 were not participant loans (they were loaned to Inland) and even if the plan allowed Loans #2 and 3, they were nevertheless prohibited transactions.
Zacky also argued that the bankruptcy court confirmed a reorganization plan for Aspects (which filed for bankruptcy) under which Aspects was to repay each loan, thereby making the loans permissible. This was of no relevance to the Tax Court. Moreover, the Tax Court did not find anything in the reorganization plan that persuaded it that Aspects would eventually repay loans because Aspects’ profit sharing plan was an unsecured creditor.
Finally, Zacky argued that the loans were made in the best interest of the plan and its participants. Factually, the Tax Court disagreed with this, and legally, even if it did agree it would have been irrelevant. In other words, if a transaction is prohibited it doesn’t matter if it was in the plan’s best interest.
4975(c)(1)(C): The direct or indirect furnishing of goods, services, or facilities between a Solo 401k Plan and a “disqualified person”
Example 1: Andrew buys a piece of property with his Solo 401k Plan funds and hires his father to work on the property.
Example 2: Rachel buys a condo with her Solo 401k Plan funds and personally fixes it up.
Example 3: Betty owns an apartment building with her Solo 401k Plan and hires her mother to manage the property.
4975(c)(1)(D): The direct or indirect transfer to a “disqualified person” of income or assets of a Solo 401(k) Plan
Example 1: Ken is in a financial jam and takes $32,000 from his Solo 401k Plan to pay a personal debt.
Example 2: John uses his Solo 401k Plan to purchase a rental property and hires his friend to manage the property. The friend then enters into a contract with John and transfers those funds back to John.
Example 3: Melissa invests her Solo 401k Plan funds in a real estate fund and then receives a salary for managing the fund.
9. Services by a Disqualified Person that are Beyond Necessary Could Trigger a Prohibited Transaction | IN RE: CHERWENKA, Cite as 113 AFTR 2d 2014-2333 (508 B.R. 228), (Bktcy Ct GA), 03/06/2014.
When it comes to performing services by a “disqualified person” with respect to real estate owned by a retirement account, IRC Section 4975(c)(1)(C) is clear that a prohibited transaction occurs in the instance of the furnishing of goods, services, or facilities between a plan and a disqualified person What is not so clear is what actually constitutes “services” when it comes to a “disqualified person” and his or her real estate investment. The Cherwenka case involved a Georgia statutory bankruptcy estate exemption for IRAs, which covered a self-directed IRA held by Michael Cherwenka who was in business of “flipping houses. Michael Cherwenka established a self-directed IRA to buy real estate.
In Cherwenka, the court considered whether a debtor could exempt a self-directed IRA utilized to invest in distressed real properties and have the IRA realize profit from the later sale of these properties. The court agreed that the Cherwenka was a “disqualified person” under IRC Section 4975. It was argued that Cherwenka performed work on the properties by researching and identifying the subject properties, appointing and approving work on the properties, and overseeing payment from the IRA custodian for such work and those acts constitute prohibited transactions under IRC Section 4975(c)(1)(C) as direct and indirect services by a “disqualified person”. The Court disagreed and held that such a position requires the Court to read out of the statute the word “transaction.” There is no evidence that Cherwenka engaged in any transaction. A transaction includes an exchange of goods or services and the evidentiary record does not include that Cherwenka received anything in exchange for his alleged services. In fact, Cherwenka testimony included that he received no money, discount, or other benefit for the identified activities he undertook with the IRA.
The Cherwenka case is really the first case that offers a detailed framework about the type of activities or tasks a retirement account real estate investor can perform without triggering the IRC 4975 prohibited transaction rules. In the case, Cherwenka was not compensated for any real property research he performed, nor was he compensated for any recommendations, management or consulting services he provided relating to how the retirement account owned properties were improved before resale. Cherwenka explained his role in buying and selling of these properties as being limited to identifying the asset for purchase and later selling the asset. Cherwenka engaged contractors to decide or oversee the scope of work with improved properties. Cherwenka testified that he “read and approved” the expense forms prior to the IRA custodian paying funds to reimburse the submitted expenses. Contractors were paid by the job, which accounted for labor costs, but no management fee or additional cost was included in the expenses submitted to the IRA custodian. Cherwenka stated he would inspect or confirm that work was completed through site visits or communication with his “team” before he would approve expenses to be paid by the IRA custodian.
Because most retirement account real estate investors tend to perform the same sort of tasks that Cherwenka performed, such as locating the property, reviewing transaction documents, engaging contractors to perform property improvements, inspection of improvements, approval of expenses, and coordinating with IRA custodian regarding the real estate, the case offers a clear blueprint for the type of activities or tasks that a self-directed IRA or Solo 401(k) plan real estate investor can do without violating the IRC Section 4975 prohibited transaction rules.
Self-Dealing Prohibited Transactions
Subject to the exemptions under Internal Revenue Code Section 4975(d), a “Self-Dealing Prohibited Transaction” generally involves one of the following:
4975(c)(1)(E): The direct or indirect act by a “Disqualified Person” who is a fiduciary whereby he/she deals with income or assets of the Solo 401k Plan in his/her own interest or for his/her own account
Example 1: Debra who is a real estate agent uses her Solo 401k Plan funds to buy a piece of property and earns a commission from the sale.
Example 2: Ben wants to buy a piece of property for $120,000 and would like to own the property personally but does not have sufficient funds. As a result, Ben uses $110,000 from in his Solo 401k Plan and $10,000 personally to make the investment.
Example 3: Nancy uses her Solo 401k Plan funds to invest in a real estate fund managed by her son. Heidi’s father receives a bonus for securing Nancy’s investment.
10. Partnering with Your Retirement Funds Could Trigger a Prohibited Transaction | IN RE: KELLERMAN, Cite as 115 AFTR 2d 2015-1944 (531 B.R. 219)
The legality of partnering with ones retirement funds to make real estate and other alternative asset investments has finally been reviewed by a Court of Law. In KELLERMAN, 115 AFTR 2d 2015-1944 (531 B.R. 219) (Bktcy Ct AR), 05/26/2015, a bankruptcy case, the court held that a partnership formed by a self-directed IRA and an entity owned by the IRA holder and his spouse personally was a prohibited transaction.
In the case, Barry Kellerman and his wife each own a 50 percent interest in Panther Mountain personally. To effect the acquisition and development of the four-acre property, the IRA and Panther Mountain formed a partnership whereby the IRA contributed property and Panther Mountain contributed property and cash. The case is a clear example that using retirement and personal funds in the same transaction can potentially trigger a self-dealing prohibited transaction under IRC 4975(c)(1)(D). By entering into a transaction with IRA funds that in some way directly or indirectly involves a disqualified person, in this case Panther Mountain, which was owned by the Kellermans’ personally, the IRA owner then is saddled with the burden of proving the transaction does not violate any of the self-dealing or conflict of interest prohibited transaction rules under IRC Section 4975, a burden that as this case shows could be difficult to satisfy. As the court stated,
“Further, and cumulatively, Barry Kellerman transferred or used “the income or assets of [the IRA]” for the benefit of each of the aforementioned disqualified persons and as a fiduciary dealt with “the income or assets of [the IRA] in his own interest or for his own account. The real purpose for these transactions was to directly benefit Panther Mountain and the Kellermans in developing both the four acres and the contiguous properties owned by Panther Mountain. The Kellermans each own a 50 percent interest in Panther Mountain and stood to benefit substantially if the four-acre tract and the adjoining land were developed into a residential subdivision.
Anyone thinking of combining retirement and personal funds in the same retirement account investment should think twice. The Kellerman case is a great example why using retirement funds and personal assets in the same transaction is not advisable and highly risky as it can potentially trigger the IRC Section 4975 prohibited transaction rules.
11. Partnering with Your Retirement Funds for a Real Estate Transaction Could Trigger a Prohibited Transaction | ERISA Opinion Letter 2006-01A
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 (the comptroller of the S Corp) IRA (31%) and George personally (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, and thus the corporation would be disqualified under Section 4975(e)(2)(G)(i).)
The DOL ruled that the transaction at issue – the purchase and lease of land from the LLC to the S Corp – was a prohibited transaction at least as to the Berrys IRA (and as such, the DOL did not reach a ruling regarding the Payne IRA as that was moot) by virtue of both Code Sec. 4975(c)(1)(A) (direct or indirect sale or exchange of property) and (c)(1)(D) (transfer to, or use by or for the benefit of, a disqualified person of the income or assets of a plan). Note that what occurred here was not a direct transaction between a plan (in this case the Berrys IRA) and a disqualified person (here, the S Corp). Instead, there was a transaction between a company (the LLC) that a plan invested in and a disqualified person. While that, according to the DOL, does not generally give rise to a prohibited transaction, the DOL 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 of Labor 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 under both Code Sec. 4975(c)(1)(A) and (c)(1)(D). While there was no direct transaction by the Berrys IRA and the S Corporation, (c)(1)(A) also applies to indirect sales or exchanges of property and that seems to be the conclusion here. The DOL noted that Mr. Payne, who managed the LLC along with George, is also a disqualified person under Code Sec. 4975(e)(2)(H) as comptroller of the S Corporation, and the fact that Mr. Payne was not independent of Mr. Berry seemed to be a factor in the DOL’s decision. The application of (c)(1)(D) also seems appropriate given that there was a transfer to a disqualified person (the S Corp) of the assets of a plan (the Berrys IRA percentage interest in the LLC’s assets, namely, the leased property).
In addition, the DOL noted that Mr. Berry, as a fiduciary to the Berrys IRA (by exercising authority or control over its assets and management) and thus a disqualified person as well, may also be in violation of the prohibited transaction rules under Code Sec. 4975(c)(1)(D) and (c)(1)(E) (act by a fiduciary where he deals with the income or assets of a plan in his own interest or for his own account)
12. A Personal Guarantee by an IRA Owner of a Loan to the Owner’s IRA is a Prohibited Transaction | Peek v. Commissioner, 140 TC 12 (2013)
A personal guarantee by an IRA owner of a loan to the owner’s IRA is a prohibited transaction (as a loan of money/extension of credit between a plan and a disqualified person under Code Sec. 4975(c)(1)(B)). But what if the loan was not made directly to the IRA but instead was made to an entity owned by the IRA? Is a personal guarantee by the IRA owner of such a loan a prohibited transaction? That was the subject of the Peek case.
Peek involved two IRA owners (Mssrs. Fleck and Peek) who jointly invested in a corporation (FP) formed by them to acquire the assets of another company (AFS). The IRAs were the only shareholders of FP. FP acquired the assets of AFS in exchange for a combination of cash and notes, including a promissory note from FP to the sellers secured by personal guarantees from both IRA owners.
Mssrs. Fleck and Peek were fiduciaries of their respective IRAs due to retaining authority and control over such IRAs and thus were disqualified persons under Code Sec. 4975(c)(1)(A), and each IRA constitutes a “plan” under 4975(e)(1). Notwithstanding that, they argued that because their personal guarantees did not involve the plan itself – i.e., since the guarantees were between disqualified persons (Fleck and Peek) and an entity (FP) other than the IRAs themselves – the guarantees were not prohibited. This argument was flatly rejected by the Tax Court, which noted that 4975(c)(1)(B) also prohibits indirect loans and/or extensions of credit between a plan and a disqualified person and that the “obvious and intended meaning” of (c)(1)(B) “prohibited Mr. Fleck and Mr. Peek from making loans or loan guarantees either directly to their IRAs or indirectly to their IRAs by way of the entity owned by the IRAs.” The Court also agreed with the IRS that if Fleck’s and Peek’s reading of the statute was correct “the prohibition could be easily and abusively avoided simply by having the IRA create a shell subsidiary to whom the disqualified person could then make a loan.”
13. Receiving a Salary from a Company 100% Owned by a Retirement Account Could Trigger a Prohibited Transaction | T.L. Ellis TC Memo-2013-245
On October 29, 2013, the Tax Court in T.L. Ellis, TC Memo. 2013-245, Dec. 59,674(M), held that establishing a special purpose limited liability company (“LLC”) to make an investment did not trigger a prohibited transaction, as a newly established LLC cannot be deemed a disqualified person pursuant to Internal Revenue Code Section 4975.
In TC Memo. 2013-245, Mr. Ellis retired with about $300,000 in his section 401(k) retirement plan, which he subsequently rolled over into a newly created self-directed IRA.
The taxpayer then created an LLC taxed as a corporation and had his IRA transfer the $300,000 into the LLC. The LLC was formed to engage in the business of used car sales. The taxpayer managed the used car business through the IRA LLC and received a modest salary. The IRS argued that the formation of the LLC was a prohibited transaction under section 4975, which prohibits self-dealing. The Tax Court disagreed, holding that even though the taxpayer acted as a fiduciary to the IRA (and was therefore a disqualified person under section 4975), the LLC itself was not a disqualified person at the time of the transfer. After the transfer, the LLC was a disqualified person because it was owned by the Mr. Ellis’s IRA, a disqualified person. Additionally, the IRS also claimed that the taxpayer had engaged in a prohibited transaction by receiving a salary from the LLC. The court agreed with the IRS. Although the LLC (and not the IRA) was officially paying the taxpayer’s salary, the Tax Court concluded that since the IRA was the sole owner of the LLC, and that the LLC was the IRA’s only investment, the taxpayer (a disqualified person) was essentially being paid by his IRA.
TC Memo. 2013-245 is the first case that directly reinforces the legality of using a newly established LLC to make IRA investments without triggering an IRS prohibited transaction. The Tax Court ruled that a prohibited transaction had occurred because Mr. Ellis received a salary from the LLC, which was wholly owned by his IRA. Of note – the Tax Court confirmed that using a newly established LLC, wholly owned by an IRA and managed by the IRA holder does not in itself trigger a prohibited transaction.
Conflict of Interest Prohibited Transactions
Subject to the exemptions under Internal Revenue Code Section 4975(d), a “Conflict of Interest Prohibited Transaction” generally involves one of the following:
4975(c)(i)(F): Receipt of any consideration by a “Disqualified Person” who is a fiduciary for his/her own account from any party dealing with the Plan in connection with a transaction involving income or assets of the Plan.
Example 1: Jason uses his Solo 401k Plan funds to loan money to a company in which he manages and controls but owns a small ownership interest in.
Example 2: Cathy uses her Solo 401k Plan to lend money to a business that she works for in order to secure a promotion.
Example 3: Eric uses his Solo 401k Plan funds to invest in a fund that he manages and where his management fee is based on the total value of the fund’s assets.
14. Lending Retirement Funds to a Company that a Disqualified Person has Ownership in That Directly or Indirectly benefits the Disqualified Person Triggers a Prohibited Transaction | Rollins v. Commissioner, T.C. Memo 2004-60.
This case illustrates how broad 4975(c)(1)(D) may be applied. The petitioner, Mr. Rollins, owned his own CPA firm. He was the sole owner. The firm had a 401(k) plan for which Mr. Rollins was the sole trustee and plan administrator. Mr. Rollins caused the plan to lend funds to three companies, and in each of which he was the largest (9% to 33%), but not controlling, stockholder. Moreover, in one of the companies he was also an officer. Mr. Rollins signed the loan checks for the plan. In addition, Mr. Rollins made decision for each company to borrow from 401(k) plan and signed the promissory notes on each company’s behalf. The loans were demand loans, secured by each company’s assets. The interest rate was market rate or higher. All loans repaid in full, although in one company’s case Mr. Rollins made some of the loan payments on the company’s behalf intending to be repaid when that company’s business (a golf club) was sold.
The IRS maintained that the plan loans were prohibited transactions under Code Section 4975(c)(1)(D) (transfer or use of plan assets by or for the benefit of a disqualified person) and Code Section 4975(c)(1)(E) (dealing with plan assets for the fiduciary’s own interest). Mr. Rollins stated that, although he himself was a disqualified person (under both 4975(e)(2)(A) as the 401(k)’s fiduciary and (e)(2)(E) as the sole owner of the CPA firm), the borrowers were not disqualified persons and therefore no prohibited transactions occurred as there were no transactions between the 401k and a disqualified person.
The Tax Court, however, held that a Code Section 4975(c)(1)(D) prohibition did not require an actual transfer of money or property between the plan and the disqualified person. The fact that a disqualified person could have benefited as a result of the use of plan assets was sufficient. To that end, the Court noted that Mr. Rollins found that the evidence supported a conclusion that Mr. Rollins derived a benefit as “significant part owner” of each of the borrowers due to the borrowers’ ability to borrow money without having to go through independent lenders. In support of this finding, the Court cited the legislative history of Code Section 4975 (promulgated as part of ERISA in 1974) that stated that the use of a plan’s assets to purchase securities in order to manipulate the price of such securities to the advantage of a disqualified person constitutes a prohibited transaction. But the Court then went on to say that it was Mr. Rollins’ burden to prove otherwise – i.e., that the loan transactions did not constitute the use of plan income or assets for his own benefit. However, Mr. Rollins was unable to provide any evidence that the loans did not enhance, or were not intended to enhance, the value of his investments in the borrower companies and thus the Court ultimately held that the loans were prohibited transactions under 4975(c)(1)(D).
At its core, the Rollins case is a burden of proof case that illustrates the breadth of the application of 4975(c)(1)(D) as well as the difficulty of meeting that burden of proof. Mr. Rollins was not a majority owner of any of the borrowers but he was the largest shareholder for each company. And he also signed the notes for each borrower. Query is whether the same decision would have been made if, for example, Mr. Rollins was not the largest shareholder or had not, as the Court put it, “sat on both sides of the table” (e.g., by not signing the notes on behalf of the borrowers). It’s not entirely clear if those factors would have influenced the Court since it was still the disqualified person’s (here, Mr. Rollins) burden to prove that the transaction did not enhance or were not intended to enhance the value of his investments in the borrowers. That seems to be a very tough burden to meet, and moreover, as the Court noted, the fact that a transaction is a good investment for the plan has nothing to do with it. As such, caution should be exercised whenever a disqualified person is sitting “on both sides of the table.
15. Using IRA to Buy Land from a Disqualified Person would Trigger a Prohibited Transaction | ERISA Advisory Opinion Letter 93-33A
In this advisory opinion, an IRA owner proposed to use his IRA to buy land and a building of a high school founded by his daughter and son-in-law and lease the property back to the school at either fair market rent or lower rent depending on the school’s ability to pay. Presumably, this was non-profit organization, without stockholders.
The IRA owner, having discretion to invest the IRA’s assets, was a fiduciary and a disqualified person. The IRA owner’s daughter and son-in-law were the sole directors and officers of the school. As such, by virtue of 4975(e)(2)(F), they also were disqualified persons. Consequently, the DOL concluded that the proposed sale-leaseback transaction would constitute the use of IRA assets for the benefit of disqualified persons (i.e., the IRA owner’s daughter and son-in-law) in violation of 4975(c)(1)(D). It seemed that the major factor here was the arrangement to lease back the property at a rent dependent on the school’s ability to pay. In fact, the DOL broadly took the view that either 4975(c)(1)(D) or (E) would be violated if a transaction were part of an agreement, arrangement or understanding in which the fiduciary caused plan assets to be used in a manner designed to benefit any person in whom such fiduciary had an interest that would affect the exercise of his or her best judgment as a fiduciary.
16. Investing IRA in Family Partnership May Trigger Prohibited Transaction | ERISA Advisory Opinion Letter 2000-10A
The DOL ruled on whether a prohibited transaction occurred when an owner of an IRA elected to direct the IRA to invest in a limited partnership in which the IRA owner and his relatives (including his son and daughter) are partners.
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 subsequently opened a self-directed IRA and invested the IRA funds into the Partnership, which had converted to a limited partnership. Adler’s IRA owned 39.38% of the Partnership as a result of the IRA investment. Adler became the only general partner in the Partnership and directly owned 6.52% of the total Partnership interests. In addition, among Adler’s relatives who invested in the Partnership were Adler’s son (3.07% interest) and daughter (1.35%). None of Adler’s other relatives who invested qualify as family members under 4975(e)(2)(F). Adler did not have any investment management functions in connection with the Partnership (ironically, it was managed by Bernie Madoff’s investment firm). None of the funds contributed by the IRA were used to liquidate or redeem any of the other partners’ interest in the Partnership.
The DOL concluded that the IRA’s purchase of an interest in the Partnership was not a prohibited transaction under Sec 4975(c)(1)(A) – i.e., there was no direct/indirect sale or exchange between a plan and a disqualified person. The Department acknowledged that the IRA was a “plan” and that Adler was a fiduciary, and thus a disqualified person. 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. (Because Adler was a fiduciary, Adler’s son and daughter were also disqualified persons under 4975(e)(2)(F). The investment transaction, however, was between the Partnership and the IRA, so the Partnership itself had to be disqualified in order for 4975(c)(1)(A) to be implicated. Adler’s ownership of the Partnership (6.52% directly plus 4.42% via his son and daughter) did not constitute a majority interest and therefore the Partnership itself was not a disqualified person under 4975(e)(2)(G).
As to whether the IRA’s purchase violated Sec. 4975(c)(1)(D) and (E) (i.e., fiduciary prohibited transactions), the DOL would not issue an opinion as that would have involved questions of a factual nature. However, the DOL took the view that a prohibited transaction would occur if the transaction was part of an agreement, arrangement or understanding in which the fiduciary caused the IRA assets to be “used in a manner designed to benefit” the fiduciary (or any person in which the fiduciary had an interest which would affect his ability to exercise his best judgment as the IRA’s fiduciary). The DOL further noted, however, are not violated merely because the fiduciary derives some incidental benefit from a transaction involving IRA assets. 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 DOL’s views were expressly based on those representations. The DOL observed, however, that, if a conflict of interest between the IRA and the fiduciary arose either now or in the future, there would be the potential for a prohibited transaction violation under (c)(1)(D) or (E).
For example, if Alder, as fiduciary for the IRA, caused the IRA to engage in a transaction that by its terms or nature created a conflict of interest between Alder and his IRA, the transaction would violate Code Sec. 4975(c)(1)(D) and (E). Similarly, Alder cannot rely upon or otherwise be dependent upon the IRA’s participation in order for him (or persons in which he has an interest) to undertake or continue his investment in the Partnership. Finally, any kind of compensation to Alder by the Partnership either based on employment or the IRA’s investment might trigger a prohibited transaction.
17. Lending Retirement Money to a Disqualified Entity Triggers a Prohibited Transaction | Technical Advice Memorandum 9119002
Company M was 100% owned by individual A and his spouse. A was also a co-trustee of Company M’s defined benefit plan. The plan made a loan to a partnership that was 39% owned by A. The IRS ruled the loan was a prohibited transaction under 4975(c)(1)(E) since A, a fiduciary of the plan and thus a disqualified person, was dealing with plan assets for his own account. As a trustee of the plan, A had authority and control over the management and disposition of the plan’s assets. In addition, the plan’s loan was made to an entity (the partnership) in which A had a significant ownership interest, and there was no evidence refuting the assumption that A (as co-trustee) participated in the decision to make the loan to the partnership. Thus, A’s simultaneous participation in (a) the decision to make a loan of plan assets to the partnership, and (b) the subsequent benefit to the partnership, constituted dealing with the plan’s assets for individual A’s own interest.
18. Lending Retirement Funds to an Entity a Disqualified Person Has Personal Ownership in – Even if Less than 50% – Could Trigger a Conflict of Interest Prohibited Transaction | Technical Advice Memorandum 9208001
In this Technical Advice Memorandum a plan invested in a participating mortgage loan that was made to a company in which one of its minority owners, Individual M, was an investment advisor to the plan as well as an officer and director of the plan. M served as Secretary/Director of the plan, and also provided certain administrative services to the plan. The plan invested $250,000 in a participating mortgage loan in which a total of $1,025,000 was loaned to T Ltd., a limited partnership formed to acquire and operate a hotel. M was a general partner owning approximately a 7.5% interest in T Ltd.
M also wholly owned a company called Individual M & Co, through which he performed services for the plan by providing suitability reviews for prospective investments. After such a review, if an investment was deemed appropriate, M would present the investment to the two owners of the plan sponsor for their ultimate decision as to whether the plan would make the investment. Here, the same process occurred as this loan transaction was brought to Individual M & Co.’s attention by the managing general partner of the partnership which owns and operates the hotel. Individual M & Co. conducted a suitability review and then presented the transaction to the owners of the plan sponsor whereupon the owners made the decision to participate in the loan transaction. The loan to T Ltd. was evidenced by a promissory note made between T Ltd., the borrower, and Individual M & Co. as the lender, as an accommodation to all the investors, including the plan.
The IRS held that Individual M is a fiduciary (and thus a disqualified person) as an investment adviser under Code section 4975(e)(3)(B) due to the activities described above, in particular, the nature and extent of the suitability reviews that Individual M & Co. performed with respect to the proposed plan investments.
Being that Individual M owned a 7.5% interest in the borrower, T Ltd., this ownership interest created a conflict of interest between the plan and T Ltd. resulting in Individual M having divided loyalties with the plan in which he was a fiduciary. The IRS concluded that this scenario was analogous to Example 2 of section 54.4975-6(a)(6) of the Treasury Regulations. In that example, an investment adviser fiduciary recommended that a plan purchase a life insurance policy. The fiduciary disclosed that it would receive a commission should the plan purchase the policy. The plan trustee approved the purchase. The example concluded that the fiduciary engaged in an act prohibited under 4975(c)(1)(E) (as well as 4975(c)(1)(F)). As such, the IRS in this TAM likewise concluded that the loan transaction to T Ltd. was prohibited under 4975(c)(1)(E). The IRS further noted that it was also prohibited under 4975(c)(1)(D) because Individual M, as a result of his ownership in T Ltd., benefited from the transaction.
19. Case Seems to Suggest an IRA Holder Could, In Some Circumstances, Not Be Considered a Fiduciary, But IRS Guidance Suggests Otherwise | Greenlee v. Commissioner, T.C. Memo 1996-378
When a plan trustee participates in the decision to cause a plan to make a loan to an entity in which the trustee owns a significant ownership interest, the IRS will likely consider the loan a prohibited transaction, as it did in Technical Advice Memorandum 9119002. In the Greenlee case, however, there was an independent trustee that had the discretion to loan funds and the Tax Court held that was sufficient t20o preclude a finding that the transaction was prohibited.
Mr. Greenlee was an attorney who operated his practice through his 100% owned professional corporation, Gaylord W. Greenlee, P.C. He was the sole participant and administrator of the company’s profit sharing plan. As administrator, Greenlee had the exclusive authority to control and manage the operation and administration of the plan. But he was not the plan trustee. Union National Bank of Pittsburgh was the sole trustee of the plan and generally speaking had sole and complete discretion to invest trust assets as it saw fit, although it could not cause the plan to engage in any prohibited transaction.
Mr. Greenlee, as plan administrator, requested the bank, as trustee, to lend $60,000 to Tag Land, Inc., a company in which Mr. Greenlee owned an 18% interest. The bank’s trust investment committee approved the loan transaction. The loan bore interest at 15%, was evidenced by a note and was secured by a lien on a tract of land worth at least $375,000.
As a plan administrator, Mr. Greenlee was clearly a fiduciary even though he was not a plan trustee. Section 4975(e)(3)(C) provides that a fiduciary includes a person who has any discretionary authority or discretionary responsibility in the administration of a plan. As Mr. Greenlee had discretion to manage the administrative aspects of his company’s plan, he was a fiduciary and therefore a disqualified person.
However, because Mr. Greenlee did not use any of the authority, control, or responsibility that made him a fiduciary to lend the $60,000 to Tag Land, the loan was not prohibited under 4975(c)(1)(E). As plan administrator, Greenlee, had the discretion to manage the administrative operations of the plan. On the other hand, Greenlee did not have discretion to manage and invest the plan assets – that was the trustee’s responsibility and here the bank (as trustee) had the sole discretion whether or not to make the loan. Notably, the Court placed great weight on the fact that Greenlee was absent at the trustee’s discussions regarding the advisability of the loan and that the trustee independently approved the investment. Accordingly, the trustee (the bank), rather than the plan administrator (Greenlee), dealt with the income or assets of the plan when making the loan.
The Tax Court acknowledged that Greenlee requested the trustee to make the loan to a corporation in which he held an 18% interest but the Court said that this recommendation was simply a suggestion. The bank, as trustee, had sole discretion to make investment decisions for the plan and had the authority to accept or reject Greenlee’s recommendation.
It should be noted that while there was no prohibited transaction in this case because the administrator merely requested that the loans be made, the result could (and probably would) be different where the administrator directs the trustee to make the loan.
Some tax practitioners have attempted to use the Greenlee case to claim that it is possible for an IRA holder to relinquish a fiduciary relationship to his or her IRA. The IRS has held strongly that in almost all cases, an IRA holder is by default a fiduciary to his or her IRA and such a fiduciary relationship cannot be disconnected.
Determining Whether a Specific Transaction is a Prohibited Transaction
Through an arrangement between the IRS and the Department of Labor (DOL), it is the DOL’s responsibility to determine whether a specific transaction is a prohibited transaction and to issue prohibited transaction exemptions. When the IRS discovers what appears to be a prohibited transaction in an individual’s IRA, it turns the matter over to the DOL to make the determination. The DOL reviews the situation and responds to the IRS, which in turn responds to the taxpayer. If the IRA grantor wants to apply for a prohibited transaction exemption, he or she must apply to the DOL. The DOL has the authority to issue prohibited transaction exemptions. Some, known as “prohibited transaction class exemptions” (PTCEs), are available for anyone’s reliance, while others, called “individual prohibited transaction exemptions” (PTEs), are issued only to the applicant.