Entity Investments in Your IRA – Who Cares About the Plan Asset Regulations?

This article is part of a series of articles discussing some issues arising when investing your IRA into an entity, such as a limited liability company, corporation, limited partnership, or trust.  In this article we discuss the plan asset regulations and how they may impact your investment in an entity.

What are the plan asset regulations and why should you care about them if you are investing your IRA through an entity?  If the plan asset regulations apply to your entity investment, there are two major effects.  First, your IRA is deemed to own not only the equity interest in the entity but also an undivided interest in the underlying assets of the entity for purposes of the prohibited transaction rules of Section 4975.  To see how this works, suppose you want to sell a piece of real estate to your IRA.  Unfortunately, the prohibited transaction rules say you cannot sell any property to your IRA.  So can you form an LLC owned by your IRA and sell the property to that LLC instead?  The answer is no, because under the plan asset regulations selling the property to your IRA-owned LLC is the same as selling it directly to your IRA, which is prohibited.

Second, if the plan asset regulations apply, the officers, directors and managers of an entity may be considered fiduciaries of the investing IRA, which means the prohibited transaction rules apply to them and other disqualified persons related to them.  This is a critical issue and has many implications.  Basically all of the prohibited transaction restrictions which are imposed on the IRA owner now also apply to the managers of the LLC.  As fiduciaries they are responsible for making decisions in the best interests of the IRA as opposed to their own best interests or the interests of parties related to them.  For example, suppose an LLC is formed which is subject to the plan asset regulations.  Because the manager of the LLC is now a fiduciary of the investing IRA, neither the manager nor any other disqualified person related to the manager may sell property to, exchange property with, or lease property from the LLC.

Because of the serious implications of these regulations, when investing your IRA through an entity you should evaluate whether or not they apply.  If you are forming an entity or advising clients as an attorney, knowing when these rules apply is crucial since it may affect how the entity is structured and whether or not you agree to accept retirement plan money.

When do the plan asset regulations apply?  The plan asset regulations apply to any investment which is not a publicly offered security or a mutual fund unless either 1) the entity is an operating company (essentially, a business), which can include a real estate operating company or a venture capital operating company or 2) equity participation in the entity by benefit plan investors is not significant (meaning total retirement plan investors own less than 25% of each class of securities).   This means that the plan asset regulations will apply unless the entity either is running a business (in which case the unrelated business income tax rules apply) or unless all retirement plan investors together own less than 25% of each class of securities.  Even if the entity meets the requirements for an operating company, the regulations still apply if an IRA or a related group of IRA’s own all of the outstanding shares of the entity.

According to an additional set of regulations which stem from the Department of Labor’s Interpretive Bulletin 75-2, even the investment in the entity itself may be a prohibited transaction if a fiduciary (including the IRA owner) causes the plan to invest in an entity and as a result of that investment the fiduciary or another disqualified person derives a current benefit.  For example, if the IRA invests in or retains its investment in an entity and as part of the arrangement it is expected that the entity will hire the fiduciary or a related disqualified person, such arrangement is a prohibited transaction.  Under those same regulations, if a transaction between a disqualified person and an IRA would be a prohibited transaction, then it will ordinarily be a prohibited transaction if the IRA and other disqualified persons collectively have voting control in the entity.

There is no doubt that this is a complex topic which is hard to explore in a short article.  In most cases, the plan asset regulations will apply to your IRA’s entity investment.  If so, you should be aware of the following implications:

1)         Your IRA’s assets include a proportionateinterest in each company asset.

2)         Company managers, directors, officers and advisers are likely fiduciaries of the IRA.

3)         Because they are likely fiduciaries, certain compensation and indemnification plans for officers and directors may give rise to prohibited transactions.

4)         Prohibited transactions may result if the company engages in business transactions with disqualified persons, including the company’s managers, directors, officers, advisers and related parties to them.

If you hire an attorney or a company to assist you in setting up an IRA-owned LLC or other entity, including the “checkbook control” LLC, make sure they have a complete understanding of the prohibited transaction rules of Section 4975 and the associated regulations, the plan asset regulations, and the regulations from Department of Labor’s Interpretive Bulletin 75-2.  Sadly, there is a perception that investing an IRA through an entity is somehow a “prohibited transaction washing machine” which will protect the IRA from all the pesky rules of Section 4975.  In fact, the opposite is true, since the additional layers of complexity make it more likely that an inadvertent prohibited transaction may occur.

For those who want to know more, the prohibited transaction rules may be found in Internal Revenue Code (26 U.S.C.) Section 4975.  The regulations for Section 4975 are in 26 C.F.R. 54.4975-6.  The plan asset regulations are in 29 C.F.R. 2510.3-101.  The regulations relating to Department of Labor Interpretive Bulletin 75-2 are found in 29 C.F.R. 2509.75-2.