In our practice, we occasionally see transactions structured by other financial planners attempting to circumnavigate the Prohibited Transaction Rules found in Internal Review Code sec. 4975, by using the thresholds found in the “Plan Asset Rule.” Dept. of Labor Regs. Sec. 2510.3-101. As is typical with most prohibited transactions, these arrangements often involve the IRA or Plan owner on both sides of the transaction, e.g., with the retirement funds being used to benefit or facilitate a transaction in which the IRA or Plan owner, or some related entity is involved. An example of this type of transaction is when IRA funds are used to purchase a building, which is then leased to the IRA owner or his business.
The Plan Asset Rule sets forth when the assets of an entity in which a retirement plan invests are deemed assets of the plan itself for purposes of determining whether a transaction is prohibited under sec. 4975. More particularly, the Rule provides that when a Plan, its participants and fiduciaries, collectively, own less than 25% of an entity “engaged primarily in investing and reinvesting assets,” its assets will not be deemed plan assets. If the entity involved is an “operating company,” ownership less 100% can result in entity assets being deemed not to be Plan assets. Such “operating companies” can include “real estate operating companies” and “venture capital operating companies.” In order to qualify as one of these operating companies, the entity must satisfy certain requirements concerning “the production or sale of a product or service other than the investment of capital,” or the ownership and management of real estate or venture capital investments. Accordingly, by setting up entities and structuring ownership to fall on the side of these percentages whereby entity assets are not deemed “Plan Assets,” some advisers or plan owners hope to facilitate a transaction that would otherwise be prohibited under sec. 4975. A typical strategy is to set up an entity to be an “operating company,” e.g. an LLC, owned mostly by the Plan (or IRA) with a small percentage owned by an outside entity or person. Then, for example, the Plan/IRA owner directs the LLC to purchase property and lease it back to the Plan/IRA owner or his/her business.
However, in so doing, plan owners or their consultants fail to account for the much broader tests for prohibited transactions under sec. 4975(c)(1)(D) & (E), which state that a prohibited transaction includes, any direct or indirect –
(D) transfer to, or use by or for the benefit of, a disqualified person of the income or assets of a plan;
(E) 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.
In gauging whether a Plan/IRA owner, as a disqualified persons, is using, benefitting from, or dealing with plan assets or income in his/her own interest, the IRS does not limit itself to examining whether he/she is not paying fair market value rent. The mere fact that there is a potential conflict of interest is deemed sufficient. For example, if the Plan/IRA owner could not pay rent in the future for a period of time, would he/she instruct the Plan/IRA LLC to initiate eviction proceedings?
Additionally, Department of Labor, Employee Benefits Security Administration (EBSA) has stated in Advisory Opinion 2006-01A:
“ . . . a transaction between a . . . disqualified person under the Code . . . and a corporation in which a plan has invested (i.e., the LLC) does not generally give rise to a prohibited transaction. However, in some cases it can give rise to a prohibited transaction. Regulation section 2509.75-2(c) and Department opinions interpreting it have made clear that a prohibited transaction occurs when a plan invests in a corporation as part of an arrangement or understanding under which it is expected that the corporation will engage in a transaction with a party in interest (or disqualified person).”
If the transaction is determined to be prohibited, the entire Plan/IRA may be deemed distributed subject to taxation plus a 10% early distribution penalty if the Plan/IRA owner is under 59 & 1/2 in age. Additionally, if someone other than the Plan/IRA owner or beneficiary participates in the prohibited transaction, that person could be liable for up to a 115% penalty (15% initially and an additional 100% if not corrected prior to receiving a notice from the IRS). An example of such a person could include a business owned by the Plan/IRA owner. See IRS Publication 590.
Even if such a transaction could be structured to avoid being deemed a prohibited transaction, there is also a possibility that rental income from the property would be deemed Unrelated Business Income and taxable at corporate tax rates. For example, if a Plan/IRA set up an LLC to be qualify as a “real estate operating company,” it would require a certain amount of active involvement in managing real estate, rather simply collecting rent. Such active involvement may conflict IRA investment rules. Under IRC §513(a), an “unrelated trade or business” is one that is not substantially related to the exempt purpose or function of the exempt entity (i.e. an Plan/IRA). This includes any trade or business regularly conducted by a Plan/IRA, which are not supposed to conduct a trade or businesses. IRC §§ 408(e)(1) and 511(a)(2). Passive investment income is specifically excluded from Unrelated Business Income Tax (UBIT), unless is it is from a leveraged investment or a controlled entity. IRC § 512(b). UBIT rates are between 15% and 39% but reach 25% after only $50,000 in unrelated business taxable income; 34% after $75,000; and 39% after $100,000. See instructions to IRS form 990-T.
Thus, as a rule of thumb, if you are contemplating using your retirement plan or IRA funds in an arrangement where you are on both ends, e.g., property owner and tenant, you are probably risking a prohibited transaction, despite the use of in-between entities and Plan Asset Rule maneuvering. While, retirement plan funds can be invested in almost any kind type of asset, arms-length transactions are the paramount principle. There may be alternative strategies for buying property for your business with your retirement plan funds (think 401(k) & Employee Stock Ownership Plan exemption) but not everyone will be positioned to pursue such a strategy and it would require some fairly complex planning.
IRS CIRCULAR 230 DISCLOSURE: To ensure compliance with requirements by the IRS, we inform you that any U.S. tax advice contained in this communication (including any attachments) is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein.