Entrust Learning Center > Keyword: self-directed > Self-Directed IRAs: An Estate Planner's Primer on Some of the Rules

Self-Directed IRAs: An Estate Planner's Primer on Some of the Rules

Note: This article is published with permission from the Oakland County Bar Association of Michigan

By: Daniel P. Marsh

IRA & 401(k) Insights

As this little-known technique is growing in popularity, advisors should know the basic rules that must be considered when contemplating alternative assets in an IRA.

Retirement plans are not limited to stocks, bonds and mutual funds, but can also invest in real estate, partnerships or equity in a closely held business by purchasing such assets through a self-directed retirement plan. Individual retirement accounts (IRAs) have long been able to invest outside the stock market when using an IRA as the means to make such investments; the technique is referred to as using a “self-directed IRA.” It was not until recently that there has been significant interest in placing non-traditional, alternative investments into an IRA.

Self-directed IRAs can be invested in traditional stocks and bonds when the IRA owner believes the skill and experience exist to pick and choose the investments of the account. In addition, these accounts can be invested in alternative types of investments such as limited liability companies, limited partnerships, mortgage receivables, promissory notes or real property.
Increasing Interest in Investments in Alternative Assets
There is growing interest in investments in alternative assets. A poll conducted by Rydex Advisor Benchmarking Inc. concluded that there is a growing trend indicating advisors are increasing their use of alternative investments such as hedge funds, real estate and commodities.  

The poll found that:
•    55 percent of advisors expect to increase their allocations in alternative investments by 25 percent over the next five years, and
•    13 percent plan to increase their use of the investments by more than 75 percent.
•    Alternative investments are becoming increasingly important to advisers.

Size of the IRA Market
The Investment Company Institute reports the total U.S. retirement assets were $14.4 trillion as of June 30, 2009, up 7.4 percent from $13.4 trillion on March 31, 2009. Retirement savings accounted for 34 percent of all household financial assets in the United States. IRAs held $3.7 trillion at the end of the second quarter of 2009, up from $3.4 trillion at the end of the first quarter. The Employee Benefit Research Institute (EBRI) reports that within IRAs, a majority of those IRAs are from rollover IRAs.

These reports indicate significant movement of retirement accounts and the assets they are holding for investment. Today’s estate planner must have an understanding all of the tax and other ramifications of estate planning for IRAs.

Clients are seeking options to support decisions for taking the best approach in their circumstances concerning their IRA investments. The attorney should have the knowledge and experience as a legal, tax and trust specialist to assist clients and their advisers develop an estate plan strategy for the IRA that suits the client’s needs. This article discusses a method to facilitate alternative or non-traditional investments with an IRA and provides a general overview of the rules that must be considered when contemplating this technique.

What is a Self-Directed Individual Retirement Account?
A self-directed IRA is an IRA in which the account owner has control and decision-making authority over the IRA investments. “Self-directed IRA” does not imply a different type of IRA, or a separate set of IRS rules. The term “self-directed” does not actually have any legal connotation. Self-directed IRAs are similar to traditional IRAs except that a self-directed IRA is one in which the IRA owner is not limited to the IRA trustee’s or custodian’s investment options, but instead can choose his or her investment options. The IRA owner can still purchase publicly traded investment options such as stocks, bonds and mutual funds as well as non-publicly traded assets like real estate or private placements (pre-IPO stock, Limited Liability Company membership, Limited Partnerships, etc.) Additional investment options permitted under the regulations include, but are not limited to real estate, stocks, mortgages, franchises, partnerships, private equity and tax liens. Self-directed IRAs, by allowing a wide range of investment choices, improve the account owner's opportunities to diversify their IRA portfolio(s).

The Rules for IRAs
An IRA is a federal income tax construct. It is a type of trust recognized by the IRS to hold funds tax-advantaged for the benefit of an individual or the individual’s heirs. The account is set up as a custodial account where the individual accountholder is the depositor and owner of the account and a qualified institution serves as a custodian of the IRA under the Internal Revenue Code. An IRA is defined as “a trust created or organized in the United States for the exclusive benefit of an individual or his beneficiaries” as long as the trust meets certain criteria. It must be established by a written document and must meet all of the requirements of Internal Revenue Code (IRC) 408(a).

Although the IRC defines an IRA as a “trust,” an IRA may also be set up as a “custodial account” that will be treated as a trust for federal income tax purposes.  A custodial account for purposes of an IRA is merely a deposit account of an individual that is maintained and held by a bank, financial institution or other person designated by the Secretary of the U.S. Treasury to act as an IRA custodian. An IRA trustee or custodian must be a bank or another person (nonbank trustee) who demonstrates that the person can and will administer the trust or account in a manner consistent with the requirements of IRC 408. As mentioned earlier, all such IRAs are to be held by a qualified trustee or custodian and must be approved by the IRS to hold IRA assets. An IRA custodial account will be subject to Michigan banking laws if the IRA is administered by a bank or other financial institution that qualifies as a bank under Michigan banking laws. IRAs cannot be self trusteed by the IRA owner.

An IRA Must Be in Writing; Model IRA Agreements
Whether an IRA is set up as a trust or custodial account, there must be a written instrument that establishes and governs the trust or account. There is no requirement that any particular form be used to establish an individual retirement account. It is only required that there be a written agreement between the trustee or custodian and the taxpayer that meets certain requirements. The written governing instrument creating the IRA must contain certain provisions that vary based upon whether the plan is created by contribution or by rollover.

The IRS has issued forms 5305 (model agreement for a trust account) and 5305A (model agreement for a custodial account) as Model IRA Agreements. Form 5305A is clear that the IRA owner may direct investments and such direction by the IRA owner will not cause the assets of the IRA to be treated as owned by the IRA owner. Most IRA agreements offer a choice of some sort of institutionally managed product (bank-managed) or what is referred to as a “self-directed” account. In the bank-managed product, the IRA owner is asked to select an investment objective and then allows the institution to make investment decisions and trade on the account based upon the investment objective established by the IRA owner. In contrast, a self-directed account will have all of the investments chosen by the IRA owner.

Prohibited Investments and Prohibited Transaction Rules

Prohibited Investments
There are very few restrictions on what a self-directed IRA may invest in. Almost anything that can be documented, other than specific asset types referenced below, can be purchased in a self-directed IRA.

The Internal Revenue Code states there are only two prohibited investments: life insurance contracts and collectibles. Collectibles include any work of art, any rug or antique, any metal or gem, any stamp or coin, any alcoholic beverages, or any other tangible personal property specified by the Secretary. There are exceptions to what is a collectible—a plan may invest in gold, silver, platinum or palladium bullion and a plan may invest in any U.S.-minted gold, silver or platinum or palladium bullion. To the extent that an IRA invests in a prohibited collectible, that amount is treated as having been distributed to the IRA owner.

However, there is one more investment that is prohibited, although this restriction is not contained in the IRA-related law, but in the law defining eligible owners for this asset: stock in a subchapter “S” corporation. The IRS says the only trusts that can be S-corporation shareholders are grantor type trusts, qualified subchapter S trusts or Electing Small Business trusts. An IRA is not specifically mentioned in the code or regulations, and so is not a trust eligible to be an S corporation shareholder (except in the case of certain S -orporation banks). Thus having an IRA as a shareholder in an S corporation invalidates the subchapter S election.

The Prohibited Transaction Rules
Prohibited transactions are defined at IRC 4975.   That code section imposes a penalty tax on “disqualified persons” engaged in specified transactions with qualified plans, individual retirement accounts, and individual retirement annuities.
Although there is no provision in the IRC that defines permissible investments, the IRC does address prohibited transactions. The following are prohibited transactions defined in IRC 4975(c) (1):

(A) the sale, exchange, or leasing of any property between an IRA and any disqualified person;
(B) the lending of money or other extensions of credit between an IRA and any disqualified person;
(C) the furnishing of goods, services, or facilities between any disqualified person and an IRA;
(D) the transfer to any disqualified person or use by any disqualified person (or for the disqualified person’s benefit) of the income or assets of an IRA;
(E) an 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
(F) the receipt by any disqualified person of any consideration in connection with a transaction involving an IRA.

For IRAs, the following definitions of “disqualified person” include, but are not limited to:
•    IRA holder (considered to be a fiduciary in a self-directed IRA) See 4975(e) (2) (A)
•    IRA holders spouse See 4975(e) (2) (F)
•    IRA holder’s ancestors See 4975(e) (2) (F)
•    Any spouse of lineal descendants See 4975(e) (2) (F)
•    Any spouse of lineal descendants of the IRA holder See 4975(e) (2) (F)
•    Investment managers and advisors See 4975(e) (2) (B)
•    Anyone providing services to the plan See 4975(e) (2) (B)
•    Any corporation, partnership, trust, or estate in which the IRA owner individually has a 50 percent or greater interest. See 4975(e)(2)(C), (D), (E),(I),(G), and (H)

Three factors must be present for a prohibited transaction to exist. There must be 1) a transaction that takes place between 2) the plan (or IRA) and 3) a disqualified person. Provided that an IRA does not engage in a prohibited transaction, alternative types of investments will not disqualify the account and will allow the IRA owner to achieve tax-deferred growth.

Penalties for Engaging in a Prohibited Transaction

If a transaction within an IRA is deemed prohibited, it can result in the disqualification of the entire account as of the first day of the tax year in which the transaction occurred and all assets of the account are considered distributed. In this event, the account loses its exemption from income tax and the fair market value of the entire account, as of the first day of the year, is included in gross income. Also, there is a 10-percent early withdrawal penalty if the account holder is less than 59 ½ years of age. The penalties for the account holder are severe, but harsh punishment is also foisted upon the disqualified person involved in the prohibited transaction. For the disqualified person involved in the transaction, there is an imposition of an excise tax of 15 percent on the amount involved. The disqualified person additionally must pay a 100-percent penalty if the transaction is not corrected within the taxable period.

Unrelated Business Income Tax And Unrelated Debt Financed Income
Apart from the prohibited transactions listed above, there are additional pitfalls that involve possible Unrelated Business Income Tax (UBIT). Retirement plan income that is generated from a trade or business regularly carried on by such account that is not substantially related to its tax-exempt purpose could be subject to UBIT. When a retirement account is subject to the tax on unrelated business income, it is generally taxed under the rules and rates that apply to trusts, which is ordinary income at the trust tax rate. The tax is payable by the IRA.

An individual can make only cash contributions to an IRA, except in the case of a rollover contribution. Real estate cannot be contributed to an IRA. However, an IRA can purchase real estate with IRA funds for investment purposes so long as the purchase is not a prohibited transaction under IRC 408(e)(2)(A). The IRA can loan funds as well as borrow funds for the purchase of real estate.

The IRA can also borrow funds to purchase investment properties under certain conditions. This leveraging of real estate can create Unrelated Debt-Financed Income (UDFI). There are banks that specialize in making loans to IRAs.  When leverage is used to purchase real property in an IRA, a proportionate part of the income, including rental income and gain when the property is sold, is unrelated business taxable income. Gains from the sale of real estate are generally not unrelated business income, unless the property is inventory or held for sale to customers for a trade or business, or the gain is debt-financed income.

Michigan Self-Directed IRA Case: Aebig V. Cox
For a discussion on the intersection of prohibited transactions rules, disqualified persons, federal law and state law, see Michigan Court of Appeals case Aebig v. Cox. The case dealt with a self-directed IRA that held real property and leased it to a corporation of which the IRA accountholder’s spouse was the sole shareholder. The IRA accountholder had a money judgment against him. The plaintiff sought satisfaction by executing on the property held in the IRA. The IRA accountholder defended against the execution by trying to establish that since the real property was held in an IRA, it is exempt from executions to collect on a judgment provided under MCL 600.6023(1) (k).  The court disagreed when it found that the IRA had entered into a “prohibited transaction” under IRC 4975(c) (1) (A) when the IRA accountholder had improperly leased the property to a subchapter S corporation solely owned by the accountholder’s spouse. As a result, the IRA ceased to be an IRA under IRC 408(e) (2) (A) of the Internal Revenue Code.

The court discussed what a “disqualified person” is in this case. The court recognized that the IRA accountholder’s spouse personally would be a disqualified person because she is “a member of the family” under IRC 4975(e) (2) (F), the definition of which includes a spouse, citing IRC 4975(e) (6). However, since the transaction was between the IRA and the corporation, most of the list of disqualified persons could not apply because it refers to individuals. The court then looked to IRC 4975(e) (2) (G) to disqualify the corporation as follows:

a corporation, partnership, or trust or estate of which (or in which) 50 percent or more of –

(i) the combined voting power of all classes of stock entitled to vote or the total value of shares of all classes of stock of such corporation,
(ii) the capital interest or profits interest of such partnership, or
(iii) the beneficial interest of such trust or estate, is owned directly or indirectly, or held by persons described in subparagraph (A), (B), (C), (D), or (E).

Since the accountholder’s spouse owned more than 50 percent of all stock in corporation that was leasing the property owned by the IRA, and she is a person listed under IRC 4975(e)(2)(A) through (E), the corporation that she owns is a disqualified person.

The court also analyzed direct or indirect ownership under IRC 4975(e) (2) (G). Under IRC 4975(e) (4), “indirect stockholdings which would be taken into account under [26 IRC 267(c)]” are included for the purposes of IRC 4975(e) (2) (G) (i). Among other provisions, IRC 267(c) (2) states:

“[a]n individual shall be considered as owning the stock owned, directly or indirectly, by or for his family.” By operation of 26 USC §§ 267(c) (2), 4975(e) (2) (F), and 4975(e) (4), the Account Holder was considered an indirect owner for the purposes of 26 USC 4975(e) (2) (G). Therefore, if either the Account Holder or his spouse qualify under § 4975(e) (2) (A) through (E), the corporation would be a “disqualified person.”

The court also found the account holder was a “fiduciary.” The IRA was recognized as a self-directed IRA since the Account Holder managed and controlled the IRA. As a result, the accountholder was found to be a fiduciary of the IRA as defined by IRC 4975(e) (3), since the accountholder is one who “exercises any discretionary authority or discretionary control respecting management of such plan or exercises any authority or control respecting management or disposition of its assets” or who “has any discretionary authority or discretionary responsibility in the administration of such plan.” Since a fiduciary is a “disqualified person” by operation of IRC 4975(e)(2)(A), then the accountholder’s indirect ownership of the corporation leasing property owned by the IRA, as a person described in subparagraph (A), renders the corporation a “disqualified person” under subparagraph (G).

Conclusion
Self-directed IRAs have been an option for investors since 1974. The use of the technique is growing. Estate planning attorneys may be asked by their clients whether this legal. The Michigan case Aebig demonstrates the technique is recognized and supported in law. An investment advisor can help the client determine whether the investment is commensurate with the client’s goals and expectations, but it is the attorneys that can help the client understand the rules and potential pitfalls of using an IRA to invest in non-traditional and alternative assets. Even though a self-directed IRA can be used to invest in alternative assets, the question for a particular client may be, “Just because it can be done, should it be done?”

After graduation from Thomas M. Cooley Law School in 1991, Daniel P. Marsh served as an attorney in the U.S. Army Judge Advocate General’s Corps and as an officer with the rank of major in the Michigan National Guard. After serving active duty, he entered private practice, focusing on probate and estate planning and taxation. Marsh has completed academic requirements for the LL.M. (in Taxation) program at Thomas M. Cooley Law School and the Probate and Estate Planning Certificate Program, cosponsored by ICLE and the Probate and Estate Planning (PEP) section of the State Bar of Michigan. He is a member of the Oakland County Bar Association and the State Bar of Michigan and their Taxation and PEP sections. Marsh is co-chairperson of the Michigan Uniform Power of Attorney Act Committee, a subcommittee of the State Bar’s PEP Section; and is also a liason from the PEP section to the Real Property Law Section.

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