On September 30, 2013, I was in U.S. Bankruptcy Court for a hearing regarding, among other things, an IRA prohibited transaction issue. The plan was for me to be called as an expert witness with respect to the debtor’s case. The other side objected because of late notice (given on Friday, September 27th) and the fact that I would testify as to legal issues (which the judge can decide). The judge sustained the objection. However, the judge gave the debtor and the debtor’s counsel the option for me to serve as part of the debtor’s counsel. I did so for the hearing. Eventually, I provided the closing argument as to the IRA prohibited transaction issues. I never became counsel of record for the debtor with the Bankruptcy Court.
Two significant issues were raised at the hearing regarding the possibility of a prohibited transaction with respect to the IRA of the debtor. Both issues are discussed below. The debtor maintains a self-directed IRA, and he “flips” houses, sometimes having the houses rehabilitated before sale. When he rehabilitates them, he either hires contractors to do the work or pays a company in which he holds a minority interest (the “LLC”) to do the work, which in turn hires the contractors. The debtor performed no work on the houses and no profit was made by the LLC.
Self-Directed IRA Activities. The first issue was whether the choosing of contractors to perform services on IRA-owned houses and follow-up to make sure the services were performed was a prohibited transaction. These services may have been performed by the LLC or the debtor. In either case, I argued there was no prohibited transaction.
I argued that because the debtor owned less than 50 percent of the capital and profits interests of LLC that provided services, it was not a disqualified person. (The remaining majority interest was owned by an individual unrelated to the debtor.) As such, the LLC was not a disqualified person under Internal Revenue Code (“Code”) §4975. Thus, services performed by it for the IRA do not fall within the ambit of the prohibited transaction rules.
I next argued that service provider choices made and job completion inspection performed by the debtor should not qualify as prohibited transactions. Rather, these types of services can be performed by creators (hereafter, “owners”) of self-directed IRAs. Provided the debtor did not work on the houses and the amount he paid was reasonable, there were no prohibited transactions.
I noted many things in my closing argument, including that the Code and its related regulations do not provide clear guidance on exactly what is permitted activity with respect to IRAs. In this regard, I said the prohibited transaction rules were enacted by the Employee Retirement Income Security Act of 1974 (“ERISA”) with a primary goal of regulating employer plans. Fiduciary duties were created to apply to employer plans, including prohibited transactions rules that prohibit certain activities. These provisions can be found in Title 29 of the U.S. Code (i.e., the Labor Code). IRAs were also created by ERISA, and the fiduciary duties applicable to employer plans were in large part copied to apply to IRAs and employer plans in the Code.
I acknowledged that the debtor should qualify as a fiduciary, and thus as a disqualified person. I then argued several things, while making reference to an outline I created in March of 2013 for submission to the American Association of Attorney-CPAs. If read from the outline with respect to a few points.
Opposing counsel argued (after I had argued) that regulations exist with respect to self-directed IRAs and they prohibit the actions that had occurred. They further argued that those regulations prohibit premature distributions from self-directed IRAs. I did not get a chance to rebut, so I did not get a chance to point out that no such regulations exist. However, the judge offered the opportunity for us to supply briefs to make our points. We did so a few weeks after the hearing.
In my closing argument, I noted that there are a few regulations that relate to IRAs and tax-qualified plans (i.e., employer retirement plans) in general. The most pertinent provision is Treas. Reg. §54.4975-6. Subsection (5) of this regulation relates to the less objective of the prohibited transactions, found in paragraphs (E) and (F) of Code §4975(c)(1). The first four paragraphs (A-D) of Code §4975(c) cover: (A) sales or exchanges, leases; (B) loans; (C) furnishing of goods, services of facilities; and (D) transfers to or use for the benefit of a disqualified person the income or assets of the plan (thus covering personal use of a plan asset). Paragraph (E) relates to dealing with the income or assets of a plan (or IRA) by a fiduciary for his own account (i.e., for personal benefit outside retirement growth of the IRA or plan). Paragraph (F) basically relates to kickbacks.
I noted that Treas. Reg. §54.4975-6(a)(5) provides in clause (iii): “Services without compensation.—If a fiduciary provides services to a plan without receipt of compensation or other consideration . . ., the provision of such services does not, in and of itself, constitute an act described in section 4975(c)(1)(E) or (F).” This provision suggests that the Treasury Department does not believe that uncompensated services constitute a prohibited transaction under paragraph C. Otherwise, there would be no need for this language. Perhaps more importantly, subsection (d) of Code §4975 provides that, except as provided in subsection (f)(6), the prohibitions provided in subsection (c) shall not apply to . . .” the listed subsection (d) exemptions. Thus, if a transaction falls within subsection (d), it is exempt. (Code §4975(f)(6) would not apply because it applies only to employer plans.)
An uncompensated service could be considered a noncash contribution to an IRA. While the Code only contemplates cash contributions, it is unclear what the impacts would be of a noncash contribution, assuming it is not a prohibited transaction. Nondeductible contributions to IRAs are subject to a 6 percent excise tax under Code §4973. Perhaps such contributions are subject to this tax.
I also noted that there is no way to eliminate complete discretion. I analogized to the employer plans situation, where the employer looks to minimize fiduciary exposure by minimizing the number of fiduciaries. However, there will always be an element of discretion, including oversight of those who pick investments. The same is true with respect to IRAs. The IRS knows and accepts self-directed IRAs. These vehicles permit basic decision-making by the IRA owner.
The 45/55 Joint Venture. The other issue presented is whether prior investment of personal funds by the debtor and IRA funds simultaneously to purchase a house with one owning 45 percent and the other owning 55 percent is a prohibited transaction. I noted that in DOL Advisory Opinion 2000-10A, the DOL issued its opinion that such an arrangement does not, in and of itself, result in a prohibited transaction. (The situation was analogous.)
I noted that the DOL (and the IRS) generally tends to either be neutral or to favor the federal government in its opinions. Courts may rule more favorably to taxpayers. For example, in Zablonty v. Commissioner, 7 F.3d 774 (3rd Cir. 1993), the U.S. Court of Appeals for the Third Circuit ruled that while a sale was a prohibited transaction, the correction was to do nothing. The only implication was application of the initial five (5) percent excise tax.
