Investment issuers need to be aware of rules from the Department of Labor that could result in a violation of prohibited transaction rules if they aren’t followed. This, in turn, can lead to costly tax consequences for self-directed IRA account holders.
These DOL Plan Asset Rules, which are also sometimes referred to as the “look-through” rules, describe circumstances in which an investment issuer’s underlying assets could be considered to be assets of a self-directed IRA or other type of retirement plan. The rules apply to any type of ERISA retirement plan, including 401(k)s as well as self-directed IRAs.
Exceptions to the Rules
The potential violation of prohibited transaction rules can result from dealings with disqualified persons who may not even be known by the account holder. Fortunately, the DOL makes exceptions that allow investment issuers to operate in a way that the investment entity’s assets are not to be plan assets under ERISA.
The main exceptions are as follows:
1. The entity is an operating company. Within this context, an operating company may be a venture capital or a real estate company. These companies can be structured as partnerships, LLCs or other types of business entities as long as the company is engaged in the production or sale of a product or service other than the investment of capital.
More specifically, the venture capital or real estate operating company must invest at least 50 percent of its assets in venture capital or real estate.
2. Total investment in the entity within IRAs and other retirement plans is less than 25 percent. This exception applies if the entity is not an operating company. Note that the percentage applies to total retirement plan investments in aggregate, not just by one investor.
This exception can easily be violated if there are many owners who hold pieces of the entity within their IRAs. Since these owners may not even know each other, the exception may be violated without some or all of the investors being aware of the violation.
3. The entity is a publicly registered security. Alternatively, the entity may be registered under the Investment Company Act of 1940, such as a public, non-traded REIT, for example.
In some cases, there may be timing issues related to the plan’s initial investment related to one of these exceptions. For the 25 percent investment exception, for example, this investment percentage must be consistently monitored in order to ensure compliance.
Definition Isn’t Limited
Keep in mind that the definition of a “benefit plan investor” is not limited to 401(k) or pension plans. The Plan Asset Rules include “any plan described in section 4975(e)(1) of the Internal Revenue Code” within the definition, including IRAs. Therefore, any investment interest owned by IRAs must be considered when determining ownership by benefit plan investors.
An example helps illustrate the potential ramifications of these rules. Suppose the general partner of a hedge fund or private equity fund uses his self-directed IRA to invest in the fund. If this brings total ownership within IRAs and other retirement accounts to more than 25 percent, any transaction between the general partner and the fund could be considered a prohibited transaction.
In this case, the general partner would be a disqualified person. Prohibited transactions would include any management fees paid to the general partner that include the plan assets held in his IRA account.
Note that even if a transaction does not generate a prohibited transaction under the Plan Asset Rules, this doesn’t guarantee that a transaction might not violate the prohibited transaction rules in some other way.
Become Familiar with the Rules
It’s important to familiarize yourself with the DOL’s Plan Asset Rules. Otherwise, you could inadvertently expose self-directed IRA account holders to severe unintended tax consequences.
STRATA Trust Company is a self-directed IRA custodian that specializes in holding alternative assets within IRAs. STRATA does not provide legal or tax advice. This summary of the Plan Asset Rules is general in nature and does not discuss every issue that may apply to an investment issuer or a self-directed IRA investor. Investment issuers and investors should consult with their own legal and tax counsel in order to understand the rules in more detail and to determine how the rules may apply to their specific situations.