The question of whether your Self-Directed IRA can pay you a fee for the performance of services is often the first one posed by IRA investors when they hear about the opportunity to make alternative asset investments with their IRA. This article will explore the complex IRS rules involving the payment of fees for the performance of services by an IRA to an IRA owner, a fiduciary, or any “disqualified person.” It will also cover the ability to provide services under the tax code to your IRA as the IRA owner without compensation.
- Receiving compensation from your Self-Directed IRA is a slippery slope and should be avoided
- The prohibited transaction rules are in place so investors do not take excessive advantage of the IRA benefits
- While there are exceptions to the rules for providing services to the plan, generally, you are not allowed to receive compensation from your IRA
The IRS Prohibited Transaction Rules in a Nutshell
The Internal Revenue Code (“IRC”) does not describe what an IRA can invest in, only what it cannot invest in. IRC Sections 408 and 4975 prohibit disqualified persons from engaging in certain types of transactions.
Under IRC 4975, a prohibited transaction is defined as:
- sale or exchange, or leasing, of any property between a plan and a disqualified person;
- lending of money or other extension of credit between a plan and a disqualified person;
- furnishing of goods, services, or facilities between a plan and a disqualified person;
- transfer to, or use by or for the benefit of, a disqualified person of the income or assets of a plan;
- act by a disqualified person who is a fiduciary whereby he deals with the income or assets of a plan in his own interest or for his own account; or
- receipt of any consideration for his own personal account by any disqualified person who is a fiduciary from any party dealing with the plan in connection with a transaction involving the income or assets of the plan.
Who is a Disqualified Person?
The IRS has restricted certain transactions between the IRA 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 (IRC Section 4975(e)(2)) extends into a variety of related party scenarios, but generally includes the IRA holder, any ancestors or lineal descendants of the IRA holder, and entities in which such persons hold a controlling equity or management interest.
Application of the IRC 4975(d) Prohibited Transaction Statutory Exemptions
From the reading of IRC Section 4975(c), it appears clear that the IRA owner, nor any disqualified person, can receive compensation from an IRA or 401(k) plan:
- IRC Section 4975(c)(1)(C): furnishing of goods, services, or facilities between a plan and a disqualified person
- IRC Section 4975(c)(1)(D): transfer to, or use by or for the benefit of, a disqualified person of the income or assets of a plan
However, before one conclusively determines that a transaction is prohibited, one must also examine the statutory prohibited transaction exemptions found in IRC Section 4975(d).
IRC Section 4975(d) Prohibited Transaction Exceptions
IRC Section 4975(d) contains twenty-four (24) statutory exemptions to the IRS prohibited transaction rules found in IRC Section 4975(c). Most of the statutory exemptions are very narrow in scope and won’t apply to the majority of Self-Directed IRA questions. However, several statutory prohibited transaction exemptions are important. For example, IRC Section 4975(d)(1) allows for the 401(k) loan option. More specifically to this article, IRC Section 4975(d)(2) offers an exception to the prohibited transaction rules for the use of office space or the provision of services, such as legal, accounting, or other necessary services.
IRC Section 4975(d)(2) reads as follows:
“…any contract, or reasonable arrangement, made with a disqualified person for office space, or legal, accounting, or other services necessary for the establishment or operation of the plan, if no more than reasonable compensation is paid therefore.”
In general, most of the IRC Section 4975(c) statutory exemptions found in IRC Section 4975(d) are not available to a limited group of parties in interest, identified as “owner-employees” and IRA owners. As stated in 1.4975-6, the provisions of section 4975(d)(2) are further limited by the flush language at the end of section 4975(d) (relating to transactions with owner-employees and related persons.” Hence, IRC Section 4975(d)(2) exemption would seemingly not apply to:
- Partners who have more than a 10% capital or profits interest in a plan sponsor that is organized as a partnership (or a limited liability company taxed as a partnership);
- Sole proprietors of unincorporated plan sponsors; and
- Owners of individual retirement accounts
In general, Section 4975(d)(2) exempts the IRC 4975(c) prohibited transaction rules, payment by a plan to a disqualified person, including a fiduciary, for office space or any service (or a combination of services), if:
- such office space or service is necessary for the establishment or operation of the plan;
- such office space or service is furnished under a contract or arrangement which is reasonable; and
- no more than reasonable compensation is paid for such office space or service.
The IRS released Proposed Treasury Regulations 1-4975-6, which provides more details on the application of IRC Section 4975(d)(2) to fiduciaries, such as the IRA owner, as well as disqualified persons.
According to 1.48975-6, compensation that would not be an ordinary and necessary expense under IRC Section 162 is per se unreasonable. The IRS also includes a “facts and circumstances” test to determine whether the compensation for services or office space is “reasonable.” Whereas a service is “necessary” if it “is appropriate and helpful to the plan obtaining that service in carrying out the purposes for which the plan is established or maintained. This is where having a well drafted LLC operating agreement for a Self-Directed IRA LLC could bolster a disqualified person’s argument to being permitted to provide real estate-related service to the IRA.
Unfortunately, as per 1.4975-6, section 4975(d)(2) does not contain an exemption for acts described in section 4975(c)(1)(E) (relating to fiduciaries dealing with the income or assets of plans in their own interest or for their own account) or acts described in section 4975(c)(1)(F) (relating to fiduciaries receiving consideration for their own personal account from any party dealing with a plan in connection with a transaction involving the income or assets of the plan). Such acts are separate transactions not described in section 4975(d)(2).
In other words, the exemption provided in IRC Section 4975(d)(2) would not apply to the IRA owner since he or she is deemed a fiduciary, as per IRC Section 4975(e). Though, the exemption could be used in a narrower manner, as discussed below.
The primary reason the IRS has imposed a different set of rules for Self-Directed IRA fiduciaries and disqualified persons is best summed up by the IRS own words:
“These prohibitions are imposed upon fiduciaries to deter them from exercising the authority, control, or responsibility which makes such persons fiduciaries when they have interests which may conflict with the interests of the plans for which they act. In such cases, the fiduciaries have interests in the transactions which may affect the exercise of their best judgment as fiduciaries. Thus, a fiduciary may not use the authority, control, or responsibility which makes such person a fiduciary to cause a plan to pay an additional fee to such fiduciary (or to a person in which such fiduciary has an interest which may affect the exercise of such fiduciary’s best judgment as a fiduciary) to provide a service. Nor may a fiduciary use such authority, control, or responsibility to cause a plan to enter into a transaction involving plan assets whereby such fiduciary (or a person in which such fiduciary has an interest which may affect the exercise of such fiduciary’s best judgment as a fiduciary) will receive consideration from a third party in connection with such transaction.”
On the other hand, 1.4975-6 is clear that if an IRA owner as fiduciary provides services to a plan without the receipt of compensation or other consideration (other than reimbursement of direct expenses properly and actually incurred in the performance of such services), the provision of such services does not, in and of itself, constitute a prohibited transaction act described in section 4975(c)(1) (E) or (F). Also, the allowance of a deduction to an employer under section 162 or 212 for the expense incurred in furnishing office space or services to a plan established or maintained by such employer does not constitute compensation or other consideration.
In sum, it appears that an IRA owner can provide services to a plan without compensation without triggering the prohibited transaction rules. Furthermore, it would seem that the services would need to be appropriate and helpful to the plan obtaining the service in carrying out the purposes for which the plan is established or maintained.
Receiving Compensation from Your IRA
As thoroughly discussed above, the IRS is clear that an IRA owner, as fiduciary of the IRA, is prohibited from receiving compensation from his or her IRA, even if the services are necessary for the establishment or operation of the plan. On the other hand, 1.4975-6(a)(5)(iii), establishes that an IRA fiduciary can provide necessary services or offer office space for no compensation. In the case of an individual that is a non-fiduciary disqualified person, 1.4975-6 would seem to suggest that he or she can provide necessary services to a plan without triggering a prohibited transaction. However, the answer may not prove as simple. Below is an example from 1.4975-6 that seems to offer a different position:
F, a fiduciary of plan P with discretionary authority respecting the management of P, retains S, the son of F, to provide for a fee various kinds of administrative services necessary for the operation of the plan. F has engaged in an act described in section 4975(c)(1)(E), because S is a person in whom F has an interest which may affect the exercise of F’s best judgment as a fiduciary. Such act is not exempt under section 4975(d)(2) irrespective of whether the provision of the services by S is exempt.
Based on the above example, the determination of whether a disqualified person may provide services for a fee to a plan seems to relate to whether the individual is a fiduciary or a related party to the fiduciary. Further, it would suggest that any lineal descendant of a Self-Directed IRA owner would be prohibited from receiving a fee for providing any services to the plan.
On the other hand, below is another example from 1.4975-6 which would allow services to be provided by an employer of a fiduciary, but not itself a disqualified person.
T, one of the trustees of plan P, is president of bank B. The bank proposes to provide administrative services to P for a fee. T physically absents himself from all consideration of B’s proposal and does not otherwise exercise any of the authority, control or responsibility which makes T a fiduciary to cause the plan to retain B. The other trustees decide to retain B. T has not engaged in an act described in section 4975(c)(1)(E). Further, the other trustees have not engaged in an act described in section 4975(c)(1)(E) merely because T is on the board of trustees of P. This fact alone would not make them have an interest in the transaction which might affect the exercise of their best judgment as fiduciaries.
As a fiduciary or a disqualified person, it is not a good idea to receive any compensation for services performed in connection with a plan, even if the service is necessary and the compensation reasonable. The IRS is very focused on maintaining the independence of the IRA fiduciary and on preventing any sort of self-dealing or conflict of interest transaction involving a plan or any disqualified person.
However, 1.4975-6 seems to suggest that an IRA owner, as the fiduciary, may provide services to a plan without the receipt of compensation or other consideration without triggering the prohibited transaction rules described in section 4975(c)(1) (E) or (F).