In general, under Internal Revenue Code Section 4975, any corporation, partnership, trust, or estate in which the IRA holder holds less than 50% interest in would not be treated a s a disqualified person. In other words, the IRA and the IRA owner cannot invest 50% equally in a joint venture without triggering a prohibited transaction. In addition, the IRA’s investment cannot be made to facilitate or protect the IRA owner’s investment in the enterprise. However, the IRA and the IRA owner may form a partnership in which the IRA owner and his or her family own less than 50% of the partnership, provided the IRA owner derives no benefits (other than incidental benefits) from the IRA investment. Many IRA advisors stop here, wrongly concluding that the IRA can freely do business with any person or entity who is not a disqualified person. Internal Revenue Code Section 4975(c)(1)(E) prohibits any “act by a disqualified person who is a fiduciary whereby he deals with the income or assets of a plan in his own interests or for his own account.” There is no requirement in Internal Revenue Code Section 4975(c)(1)(E) that the person or entity on the other side of the transaction be a disqualified person. All that is required is for the fiduciary to deal with income or assets of the plan “in his own interests.”
DOL Adv. Op. 2000-10A. See also DOL Adv. Op. 89-03A, in which the IRA owner directed the IRA trustee to purchase stock of a company for which the IRA owner was an officer and a shareholder of 1% of the total shares. Due to the small number of shares owned by the IRA owner, the DOL did not find self-dealing. However, in Rollins v. Comr, T.C. Memo 2004-260 in which Rollins was the sole trustee of the §401(k) plan for his wholly owned firm. In his capacity as trustee, he caused the plan to make a series of loans to three businesses, that he and his wife owned a minority interest. The loans were repaid. The IRS maintained that the plan loans were prohibited transactions under §4975(c)(1)(D) (transfer or use of plan assets for the benefit of a disqualified person) and §4975(c)(1)(E) (dealing with plan assets for the fiduciary’s own interest). Rollins stated that the borrowers were not disqualified persons and therefore no prohibited transactions occurred. The Tax Court held that a §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.
In one advisory letter, Mr. Alder (Alder) and his family members were partners in a general partnership (an investment club) managed by Bernard L. Madoff Investment Securities (Madoff), independent of Alder. Madoff required entities under his management to maintain minimum capital accounts. With $500,000, Alder opened a Self Directed IRA which became a limited partner (39.38%) in another partnership (P). The assets of P also included assets from the prior partnership. Alder (6.52% ownership interest) and his family members also invested in P. Alder was a general partner of P. Alder did not receive any compensation as a result of his IRA’s ownership in P. P was a family limited partnership, an estate planning and creditor protection tool.
The DOL held that Alder was a fiduciary (and therefore a disqualified person) due to his investment discretion under the IRA. Alder’s son and daughter, who invested in P, also were disqualified persons. The P was not a disqualified person as Alder owned only 6.5% (less than a 50% majority share). As to the IRA’s purchase of an interest in P, the DOL ruled that the investment of the IRA assets in P did not constitute a prohibited transaction for purposes of Code §4975(c)(1)(A) (i.e., sale or exchange of property). As to whether the IRA’s purchase violated Code §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 did provide examples in which certain actions, if they occurred, could trigger such a prohibited transaction:
- 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). This would then affect his ability to exercise his best judgment as the IRA’s fiduciary. An article critiquing this DOL advisory opinion suggests that one interpretation of this statement might include an arrangement in which the fiduciary was using the IRA’s assets to gain a controlling interest in the partnership. Alternatively, if the fiduciary was using the IRA assets to benefit another family member or his business, such use would affect the fiduciary’s best judgment.
- 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 §4975(c)(1)(D) and (E). Employment of the fiduciary by the partnership, or payment of unreasonably large compensation, or compensation based on the IRA’s return on investment might trigger a prohibited transaction.